Why German bonds could be even riskier than Greece’s

Why German bonds could be even riskier than Greece’s

…. or why bond are much riskier than they are perceived

Which will be the better investment over the next 10 or even 30 years: German bonds or Greek bonds?

If that sounds like a simple question, think again.

In the fallout from Sunday’s “no” vote in Greece, the price of “safe” German bonds has surged and that of “risky” Greek bonds has, predictably, plunged.

Bonds are like seesaws: When the price goes up, the yield goes down and vice-versa.

At today’s prices, a 30-year German Bund sports a yield to maturity of only 1.4%. Meanwhile, a 30-year Greek bond offers a theoretical yield of just under 13% — i.e., nearly 10 times as much.

Naturally the markets are predicting that Greek bondholders won’t get all that money. They’ll take what is generally called a “haircut,” meaning cuts in their coupons and final principal repayment.

But how big will the haircut be?

Unless Greek bondholders suffer a massive, catastrophic write-down, they will actually end up getting more money back on their bonds than German bondholders will. That’s because “risk” and “safety” cannot be understood without reference to the price you pay for an asset. A “solid” asset can end up being a risky or poor investment if you pay too much; a dubious or risky asset, as long as it has at least some value, can end up being a great deal if you get it cheaply enough.

Both could be the case right now. Greek bonds could be underpriced. And German bonds could be overpriced. A yield of 1.4% a year for three decades looks dismal from almost any standpoint.

Mathematically, Greek bondholders will end up ahead if their haircut is less than about 73%. Yes, really. Take a 30-year bond with a theoretical yield of 12.73%, and you have to cut coupons and principal overall by more than 73% before the owner ends up earning a net return of less than 1.4% a year.

The face value of Greece’s government debt is currently 170% of economic output, or gross domestic product. A decrease of 73% would reduce that to only 46% — about the same as that of Germany. That would be some cut.


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